What’s Next for the Stock Market?

Equity markets tried to bottom out in June and rallied in July and August as inflationary and economic headwinds appeared to be easing. That respite was short-lived, however, as higher-than-expected inflation and weaker economic data sent markets back to new lows in September.

As we entered 2022, we noted that the US stock market was overvalued and would face four main headwinds this year:

  1. slowing economic growth,
  2. US Federal Reserve tightening of monetary policy
  3. Inflation is running hot, and
  4. Our expectation that long-term interest rates would rise.

What we last saw is:

  1. Even weaker than expected economic growth,
  2. The Federal Reserve has become even more restrictive
  3. Inflation is still running hot, and
  4. Long-term interest rates started to rise again, with US 10-year Treasuries up 80 basis points to almost 4% in September.

On top of these headwinds, additional pressures have emerged, including:

  1. Sharp appreciation of the US dollar, which will hurt profits for US companies with significant foreign exposure,
  2. Europe appears to be headed for a recession, the only question being how long and how deep and
  3. The economic prospects for China are particularly bleak

Stock market trading deep in undervalued territory

However, with equities having sold off 24% year-to-date, we feel the market has corrected too much lower. According to a compilation of the stocks we cover that trade on US exchanges, the stock market is significantly undervalued, trading at a discount of over 20% to fair value. Growth stocks are the most undervalued with a price/fair value of 0.75, followed by the value category at 0.77. Core shares are trading closer to fair value at 0.86. Investors appear to be best positioned with a dumbbell strategy, overweight both value and growth categories and underweight core stocks.

Across all levels of capitalization, large and mid-cap stocks trade close to broad market valuation, while small-cap stocks trade at the largest discount to fair value at 0.62.

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Morningstar Equity Research Coverage Price/Fair Value, US Equity Style Box

Source: Morningstar Equity Research. Data as of September 26, 2022.

Stocks have seldom traded at such a deep discount to intrinsic valuation

The current level of undervaluation is the largest discount to our long-term intrinsic valuations since the outbreak of the pandemic. Within the month of March 2020, the Price/Fair Value bottomed out at 0.77 on March 23, 2020.

Over a longer historical period, there have been few other instances where our price/fair value metric has fallen to similar levels. Stocks fell sharply in December 2018 as the Fed had been tightening monetary policy for a year and markets were pricing in global growth fears. In autumn 2011 there were fears that the Greek debt crisis might spread to other countries (Portugal, Italy and Spain) and that the systemic risk from the European sovereign debt crisis would spread to the European banking system.

While short-term conditions may weigh on earnings in the near-term, we believe that at current valuations the market has fallen more than enough to absorb these headwinds. In our view, the market is overly bearish on the long-term outlook for equity valuations.

Morningstar US coverage price/fair value at month-end

Source: Morningstar Equity Research. Data as of September 26, 2022

Looking ahead, expect more volatility until conditions improve

We expect markets to remain under pressure and volatility to remain high over the next six to 12 months. To bottom out, markets need clarity on when economic activity will experience a meaningful and sustained recovery and evidence that inflation will start to trend down and return to the Fed’s 2% target.

During this period we expect:

  • GDP will remain sluggish and will only accelerate again in the second half of 2023,
  • The Federal Reserve will complete tightening by the end of 2022,
  • Momentum may be driving rates slightly higher in the short term, but the preponderance of rising long-term rates is already in place, and
  • Inflation will gradually moderate over the next few months and will subside in 2023.
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We believe the combination of these factors will give the Fed the leeway it needs to start easing monetary policy by the end of 2023. Our forecast is that the federal funds rate will fall to 2.00% by the end of 2023 and the yield will continue to rise. The 10-year US Treasury bond will average 2.75% in 2023.

Communications and cyclical sectors were the hardest hit by the sell-off and are now the most undervalued

Both Meta Platforms and Alphabet underperformed the market last quarter, helping push the communications sector deeper into undervalued territory. But even excluding these two stocks, we see significant value in traditional media and communications companies. Many of these companies are in the process of building their own streaming services, and the market has been particularly pessimistic about their long-term prospects.

The price/fair value of the consumer discretionary sector remained stable at 0.75. We believe the market is overreacting to concerns about a possible near-term recession. In the event of a recession, we think it would be short and shallow and that the sector already has a reasonable margin of safety at its current valuation. Many of the service-oriented companies in this sector should benefit as the pandemic continues to recede and consumer behavior normalizes and shifts back to services and away from goods.

The largest price/fair value fall this quarter was in the real estate sector as the impact of rising interest rates took their toll on net asset values. The next largest price/fair value decline was in the energy sector. Oil prices peaked in early June and are generally on a downtrend. Energy stocks followed suit, falling sharply in September. Following this pullback, price/fair value has fallen to 0.91 from 0.99 in the last quarter.

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In general, defensive sectors have held up relatively well this year, trading closer to fair value, with utilities trending slightly towards overvalued. We expect inflation to moderate gradually, but if inflation remains more persistent, utilities would be the most negatively affected sector.

Morningstar Equity Research Coverage Price/Fair Value by Sector

Source: Morningstar Equity Research. Data as of September 26, 2022.

What now?

In such market environments, it is particularly important for investors to have a plan that balances their long-term investment goals with their risk appetite. This plan should also allow for regular rebalancing to increase stock allocations when valuations are falling but also reduce exposure when valuations stretch. Based on our view that the US stock market is undervalued, we believe now is not the time to reduce equity exposures, but rather to add them wisely, particularly in companies with large economic moats, based on your investment plan and goals.

Note: This article was originally written for a US audience

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